APPEAL FROM THE UNITED STATES TAX COURT (Tax Court No. 7887-74)
Before: WEIS, HIGGINBOTHAM, and BECKER, Circuit Judges.
The Tax Court determined the taxpayers were not entitled to deduct interest which they had paid as guarantors on notes of corporations that had been discharged in bankruptcy. We conclude that because the taxpayers had a direct and fixed obligation to pay the notes and had no recourse against the corporations, the interest is properly deductible under the Internal Revenue Code. Accordingly, we will reverse the decision of the Tax Court.
After a remand from this court, B.B. Rider Corp. v. Commissioner, 725 F.2d 945 (3d Cir. 1984), the Tax Court reaffirmed its prior ruling that interest payments made by the Stratmores were not deductible under § 163 of the Internal Revenue Code. 26 U.S.C. § 163 (1982). They have appealed.
The taxpayers were officers and stockholders in B.B. Rider Corporation and General Manufacturing Corporation, and were guarantors for certain debts incurred by those companies. In 1957, both entities filed for reorganization in bankruptcy under Chapter XI. As part of the plan for reorganization, Rider and General paid their creditors 25 cents on the dollar. The taxpayers agreed to honor their obligations as guarantors of the remaining 75 percent due on certain notes, and also stipulated they would forego their claims against the companies. In addition, the taxpayers assented to a limitation on their salaries. The plan was approved by the bankruptcy referee.
Thereafter, the taxpayers made payments to the holders of the notes and deducted those amounts as interest and bad debts. In the initial appeal, we decided that the Tax Court properly treated payments on principal as non-business bad debts. We did not rule on the interest deduction because the Tax Court had not discussed the applicability of the holding in Tolzman v. Commissioner, T.C. Memo 1981-689, 43 T.C.M. (CCH) 1 (CCH) (1981). In that memorandum opinion, the court concluded that guarantors had become primarily liable after the insolvency of a corporate debtor and were thus entitled to deduct interest under § 163. To afford the Tax Court an opportunity to address Tolzman in the first instance, we remanded the interest question.
On reconsideration, the Tax Court distinguished Tolzman by noting that there the interest was deductible because it had accrued on a state court judgment entered after litigation on a contract of guaranty. Consequently, the interest was part of a court decree for which the guarantors were directly and primarily liable, not on the original debt obligation. 48 T.C.M. at 1371.
In contrast, the Stratmores' payments of interest were found to be non-deductible because they arose from secondary obligations. Commenting that Tolzman is a memorandum opinion and as such is not controlling precedent, the Tax Court reaffirmed its earlier ruling to disallow the interest deductions under § 163.
On appeal, the taxpayers contend that they became primarily liable after the bankruptcy proceeding, which discharged the corporations of liability on the notes. The government maintains that despite the bankruptcy, the taxpayers as guarantors remained only secondarily liable. The government concedes that even though the taxpayers are not permitted to deduct the interest under § 163, they may be entitled to a full or partial deduction for the interest under § 166 as a bad debt loss.
Under § 163(a) of the Internal Revenue Code, a taxpayer is "allowed as a deduction all interest paid or accrued within the taxable year on indebtedness." Although this is a very broad provision, it was determined early in the history of the Code that the debt must be the taxpayer's direct obligation. A Treasury regulation, § 1.163-1, made an exception by permitting a deduction for interest paid on a realty mortgage even when the taxpayer was not directly liable on the bond or note secured by the property.*fn1
Observing that just one exception has been created by regulation, some courts beginning with Guardian Investment Corp. v. Phinney, 253 F.2d 326, 332 (5th Cir. 1958) have interpreted § 163 as allowing a taxpayer to deduct interest only on an obligation for which he was primarily liable at its inception. The rationale is that because the regulation created a mortgage exception, all others were thereby excluded.
The Mertens' commentary states that if the "indebtedness represents a direct obligation of the taxpayer, the interest properly due thereon is clearly deductible. But if the doctrine is not pushed too far, such interest is also deductible by a person under an equitable [duty] to pay it as having received, in substance, the benefit of the indebtedness." 4A Mertens, Law of Federal Taxation, § 26.03 (1985). As this passage and the court decisions point out, interest paid for another is generally not deductible. However, "somewhere between a strict requirement of direct liability and the obvious insufficient of payments clearly on behalf of another person, the line must be drawn." Determining who is entitled ...